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The Effect of Public Spending on Consumption: Reconciling Theory and Evidence

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  • AMBLER, Steve
  • BOUAKEZ, Hafedh
  • CARDIA, Emanuela

Abstract

Recent empirical evidence from vector autoregressions (VARs) suggests that public spending shocks increase (crowd in) private consumption. Standard general equilibrium models predict the opposite. We show that a standard real business cycle (RBC) model in which public spending is chosen optimally can rationalize the crowding-in effect documented in the VAR literature. When such a model is used as a data-generating process, a VAR estimated using the artificial data yields a positive consumption response to an increase in public spending, consistent with the empirical findings. This result holds regardless of whether private and public purchases are complements or substitutes.

Suggested Citation

  • AMBLER, Steve & BOUAKEZ, Hafedh & CARDIA, Emanuela, 2008. "The Effect of Public Spending on Consumption: Reconciling Theory and Evidence," Cahiers de recherche 2008-11, Universite de Montreal, Departement de sciences economiques.
    • Handle: RePEc:mtl:montde:2008-11
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    File URL: http://hdl.handle.net/1866/2579
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    Keywords

    Optimal public spending; Business cycles; Crowding in;
    All these keywords.

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents

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